Fed Funds 5.25% - 5.5%, US Ten Year 4.19%, Oil $76.57
The major stock indices continue upward, the Standard & Poor’s 500 now at an all-time high, even in the face of stubbornly high interest rates and indications from Federal Reserve chairman Powell that he is committed to the 2% inflation target. When it became apparent at the January FOMC meeting that a hoped-for lowering of the Fed Funds rate out of the March Fed meeting was unlikely, stocks hiccupped for a day, then sloughed it off and continued upward. How is this happening, despite rates being “higher for longer?”
The Federal Reserve controls short-term interest rates primarily through two tools, the Federal Funds rate, and its balance sheet. By purchasing government and agency debt on the open market and putting it on its balance sheet the central bank increases the money supply (“quantitative easing”) and stimulates the economy. The Fed’s first widespread use of this tool was during the financial crisis of 2007-08. The Fed also reduced the overnight lending rate from 5.25% to 0.25% to further lubricate the economy.
At present the Federal Reserve is “quantitative tightening,” removing liquidity by letting maturing securities in its portfolio return to the market and thereby reducing its balance sheet. As the treasury and federal agencies issue new securities the financial markets purchase them, soaking up dollars. Such restrictive monetary policy aims to reduce inflation.
The chart above shows the decrease in the central bank’s balance sheet. It fell by $55.2 billion in the just past four weeks as it plans to let up to $60 billion of maturing Treasury securities roll off its balance sheet each month, while also reducing holdings of agency mortgage-backed securities by up to $35 billion.
Yet stocks do not seem to care. This is because the stock market is forward-looking. From the chart below we see that the market is anticipating the first lowering of Fed Funds to come out of the June meeting. The purple line is the December reading of interest rate expectations and illustrates how much sooner the market anticipates lower rates than it did just two months earlier in October, the green line.
So, despite the current tight monetary conditions the financial markets are expecting lower interest rates sooner and for them to fall more rapidly. Meanwhile corporate earnings are strong, with 80% of companies reporting fourth quarter earnings beating estimates. These factors along with a history of stocks doing well in presidential election years (stock have ended higher in 20 of 24 presidential election years since 1928), suggest investors maintain a well-diversified portfolio of common stocks.
Wishing You a Profitable Week,